Global venture capital investments in early stage startups drops again

01 June 2016 Consultancy.uk

A shot of reality has befallen the venture capital backed startup market, as it seems investor sentiment is seeking certainties over possibilities. The total number of deals and the value of investments into early stage startups has dropped to the lowest point in two years, reflecting the growing concerns from investors. The changing fortunes within the venture capital scene are however likely to just be a short blip, as the pursuit for returns, on the back of abundant dry powder, continues.

Venture Capital backing is a key funding source for a range of startups seeking to become the next unicorn with their own innovative or differentiated offering. For venture capitalists, the sometimes high risk ventures provide a means to book serious returns on their capital investment. In recent years the startup environment has taken off – a recent report shows that venture capital funding globally jumped from $44 billion in 2012 to $128 billion last year. The heating of the market follows a number of trends, including the rise of digital technologies that have the potential to disrupt markets and the growing demand from venture capitalists seeking lucrative returns. Corporates too are playing a role – they are showing growing interest in, at an early stage, capturing the innovative potential of what may otherwise become, the competition, a movement also known as corporate venturing.

In a new report, KPMG and CB Insights look into the most recent developments in the venture capital (VC) market. The research looks at equity funding that enters emerging companies from venture capital firms, corporate venture groups or super angel investors. The study is based on verified funding from a range of federal and state regulatory filings, direct sources (i.e. investors or startups) and data from analyst agencies.

Venture capital investment in startups

Changing sentiment
Interest in investing in startups has grown considerably over the past three years as both the number of deals as well as their respective total value rose to new heights midway through 2015. At its peak, a total of $39 billion was invested in one quarter. The end of last year saw a drop off, particularly in the number of deals, which fell by almost 200 on the previous quarter, while total investment dropped to $27.7 billion. The fall reflected concern within the investment community about the true valuation of their investments, prompting hesitation. As such, much more focus is now being placed on companies that demonstrate revenue creation, positive margins, the ability to control expenses, and profitability – or a realistic path to achieve it. In some industries, investors might also evaluate other performance metrics – like customer retention, bookings or operating margin.

The negative sentiment has persisted into the first quarter of 2016, with deal volume as well as deal value falling further, to 1,829 and $25.5 billion respectively. The drop reflects a deterioration in the mega-deal market, as well as continued considerations surrounding overvaluation. “VC investors are becoming more cautious and more skeptical,” says Arik Speier, Head of Technology at KPMG in Israel. “In order for companies to attract funding – especially at the seed stage – they will need to have a stronger business plan, positive margins and a way to prove the validity of any bullish projections.”

Venture capital investment in startups by region

In terms of changes within the three key markets, North America has seen the largest fall in deal value and deal volume since Q3 2015, on the back of concerns about valuation, interest rate increases and the presidential election. Deal volume has remained relatively stable over the past two quarters, at 1,112 and 1,101 respectively. Deal value has ticked up slightly in the US, from $14.3 billion in Q4 2015 to $15.2 billion in Q1 of this year.

Asia and Europe have seen a much less sharp decline in deal volume over the past year, from 403 to 358 in Asia and from 355 to 338 in Europe. Deal value in Asia saw rapid gains during 2015, almost tripling from Q1 to Q3, before falling back to close to Q1 2015 levels by Q1 2016, at $6.5 billion. European deal value has remained stable, at around $3.5 billion across the year.

Venture capital investment per startup typeThe research also found that the types of funding available is shifting up the maturity ladder. Investors are considerably less keen to fund Seed/Angle level startups in Q1 2016 than a year previous, falling from 35% to 28% respectively. Series A funding has gained a boost, taking in 26% of the pie in Q1 2016 compared to 22% in Q1 2015. In the same period, series B funding increased ever so slightly, while ‘other’ funding types increased 2% to 18% of the total share.

Corporate Venturing in startups

Corporate innovation
The research highlights that while a number of venture capital investor types are shying away from investments, corporates are becoming increasingly active. A recent study from Arthur D. Little finds that corporates and startups are becoming increasingly close, as corporates seek to leverage the innovation potential of startups to be the first to disrupt, or transform, their own business environment. One of the modes of collaboration is through corporate deal participation into VC-backed companies. The level of participation increased to 27%, representing a 5-quarter high. Asian corporates are particularly keen to engage with startups, 32% of deals there involving corporations or corporate venture capital groups.

Anand Sanwal, CEO of CB Insights, comments: “Corporations continue to look to access innovation by engaging in corporate venture investments. A flood of new corporate VCs and existing corporate VCs becoming more active, coupled with large corporate balance sheets, suggests that the influence of corporate venture arms will grow over time.”

VC-backed companies entering the unicorn club

The research further explored the landscape to identify the number of unicorns that had come into existence within the various quarters over the past year. Unicorn creation has fallen significantly, from a peak of 25 in Q2 and Q3 2015 to 5 in Q1 2016. The creation of a unicorn is, at the best of times, difficult enough; recently unicorns have been battling negative press, as well as seeing their valuation slashed, including the likes of Square, which saw its valuation halved from $6 billion in 2014, and 58 other tech start-ups suffered “down rounds” since the start of 2015.

Future trends
The changing fortunes within the venture capital back market are likely to just be a short blip, according to the KPMG analysts. The global market still contains considerable ‘dry powder’, some of which will be hunting for unicorns. One change however, may be that rather than focusing on horses that show possibility for unicorn transformation, more focus will be on their performance. Brian Hughes, a Partner with KPMG in the US, remarks: “Overall concerns around the global economy and a decline in valuations in most parts of the world are leading investors to be far more selective than in the past. VC investors are increasingly rolling up their sleeves and looking for performance rather than possibility.”

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